Passive income is earnings derived from a rental property, limited partnership, or other enterprise in which a person is not actively involved. As with active income, passive income is usually taxable, but it is often treated differently by the Internal Revenue Service (IRS).
The Internal Revenue Service (IRS) has specific rules for what it calls material participation, which determine whether a taxpayer has actively participated in business, rental, or other income-producing activity. A taxpayer can claim a passive loss against income generated from passive activities. There are three main categories of income: active income, passive income, and portfolio income. Passive incomes include earnings from a rental property, limited partnership, or other business in which a person is not actively involved. Passive income, when used as a technical term, is defined by the IRS as either “net rental income” or “income from a business in which the taxpayer does not materially participate,” and in some cases can include self-charged interest. Passive income is generally earned from an income-producing asset that the investor is not actively involved with. Often, that asset was purchased with savings from active income sources, like wages, salaries, or other compensation. In addition to not having to spend hours a day generating passive income, investors do not pay Social Security or Medicare taxes on passive income and they can reduce their income tax liability with an array of potential tax deductions. When money is loaned to a partnership or an S corporation acting as a pass-through entity (essentially, a business designed to reduce the effects of double taxation) by that entity’s owner, the interest income on that loan to the portfolio income can qualify as passive income.
